Tips and Taxes – are you playing by the rules?
A tip or gratuity is an amount of money that is paid, voluntarily, by a customer or client in addition to the sum they are required to pay for the good or service they have received. The voluntary aspect is the key distinction between a tip and service charge, which is compulsory.
If you work in an industry in which tips are commonplace (a restaurant, for example) either as an employer or an employee, then you may not be aware that tips are classified as taxable earnings. Therefore, not only must employees pay income tax on the tips in the same way they do on their salary, but they, and their employer, may also be liable to paying National Insurance contributions (NICs).
The crucial factor in determining what tax must be paid on the tips, and who is responsible for paying it, is how the tips are distributed.
The first way that employees can receive tips is directly from the customer. An example of this would be a diner in a restaurant leaving money on the table after they have paid the bill and left. The waiter or waitress then picks this money up and keeps it for themselves. As the employer does not have any interaction with the tip, legislation states that it is exempt from NICs, however the employee must report the additional income to HMRC. HMRC will then collect the income tax due, often by adjusting their tax code.
An alternative method is for the employer to collect all the tips and then distribute them to their employees. Using the restaurant example again, the owner may wish to ensure that all staff receive an equal amount in tips, including those working in the kitchen. To achieve this, they pool all the tips together and then give everyone the same percentage of the total. With this method, the tips form part of each employee’s earnings, and therefore the employer is responsible for operating PAYE in respect of the total of their salary and tips. In addition, Class 1 NICs are chargeable in the same manner as wages.
The final way in which employees can receive tips is via a tronc, which is a pot or fund that all tips are paid in to. These are then distributed to staff via a third-party. The third-party, known as the troncmaster, can be one of the employees, however they cannot be the employer. If this method is used, and the employer has no influence over how the tips are distributed, then they are exempt from NICs. They are still liable to income tax, however, and it is the troncmaster who is responsible for operating PAYE in respect of the tips. If the employer collects the tips and then transfers the money to the tronc, then the tips are still exempt from NICs. However, if the employer has any influence over how the tips are distributed, then NICs become chargeable.
HMRC offer guidance and further detail on this topic, which can be found here. The document includes a flowchart which is helpful for determining whether NICs are due or not.
If you are an employer and were not aware of these rules, then now may be a good time to evaluate how tips are distributed at your business, otherwise you may face a hefty and unexpected tax bill in the future!